Charles Roth is global markets editor for Thornburg Investment Management. Prior to joining Thornburg in 2013, Charles was an assistant managing editor at Dow Jones Newswires, the Wall Street Journal’s real-time financial news and analysis division, where he oversaw its bureaus in Latin America as well as the New York–based emerging markets group. He had previously served as a senior writer in the emerging markets group, bureau chief in Venezuela, and staff reporter in Malaysia.

Charles earned BA degrees from the University of Colorado at Boulder and an MA from the Instituto Universitario de Desarrollo y Cooperación at the Universidad Complutense in Madrid, Spain. He was a Peace Corps volunteer in Mali.

Fed hikes rates again, even as inflation falls further from target and financial conditions continue to ease. Smooth sailing ahead? Beware the leverage risks building below the surface.

Despite weaker economic data of late, the U.S. Federal Reserve matched market expectations in raising its benchmark interest rate June 14, 2017 a quarter point, setting its new range to a still highly accommodative 1% to 1.25%. Mattering more to markets, though, was the Fed’s updated, rather hawkish guidance of one more rate hike in 2017 and the start this year of a program to gradually trim its $4.5 trillion balance sheet. Higher benchmark rates and the slow unwinding of the Fed’s balance sheet should lift long-term borrowing costs, which have lately, somewhat paradoxically, been easing.

Interestingly, if the Fed’s language was dovish when it last raised rates in March 2017, this time around Chairwoman Janet Yellen struck a more confident tone on inflation, which has ebbed since brushing up against the targeted level in February 2017. Recent weakness has been driven by price declines in cellular service packages and prescription drug pricing, the Fed noted in its statement. In subsequent remarks to the press, Yellen suggested inflation would move back toward the 2% target given a “strong labor market,” which should continue to strengthen, she added. Unemployment in May 2017 stood at 4.3%, below the 4.5% that the Fed had been targeting this year. Yellen pointed out that the labor market participation rate, which remains quite low by historical standards, has been mostly “steady,” which is a “healthy sign,” given the growing retirement of baby boomers, she said.

To be sure, as many market participants have often noted, the Fed has rather consistently overestimated growth and inflation in recent times, and has had to subsequently reset its expectations lower, closer to market forecasts. The Fed still sees inflation hitting 2% by the end of 2018, even after lowering its forecast to 1.7% this year from 1.9% in March 2017. In its latest statement the Fed said it’s “monitoring inflation developments closely.”

But the Fed lowered its unemployment projection for this year to 4.3%, and to 4.2% for both 2018 and 2019, down from the previous 4.5% forecasts for each of the three years. Meanwhile, it lifted its economic growth projection slightly for 2017, to 2.2% from 2.1% at the March meeting, and retained its previous forecasts of 2.1% and 1.9% growth in 2018 and 2019, respectively.

“We want to keep the expansion on a sustainable path, and don’t want to find ourselves in a situation in which we’ve done nothing and then have to move aggressively,” Yellen said. The Fed is now guiding toward one more rate hike this year if the economy continues to grow as expected, and three more quarter-point hikes in both 2018 and 2019, raising the Fed funds rate to 3%, which is also its projected longer-run average.

The latest increase in the Federal funds rate marks the fourth such hike since December 2015 from a near-zero level. Even as it has raised the key rate, however, financial conditions have been easing this year. That twist echoes the “conundrum,” as former Fed Chairman Alan Greenspan put it, of the policy rate tightening in 2004 and 2005, which didn’t spur tighter financial conditions in the market, allowing leverage to continue building ahead of the 2008 financial crisis. Asked about this year’s easing in financial conditions, Yellen noted the strength in the stock market, the recent decline in the dollar, which is still “substantially” stronger than it was in 2014, and added that the Fed also takes into account other factors that don’t show up in financial conditions indices.

What she didn’t address, however, was increasing leverage, not just among businesses and public sector entities, but consumers as well. While mortgage debt is lower, student loans, auto loans and credit card balances have all been climbing, Thornburg’s Jason Brady notes. Unlike in 2015 and most of 2016, when “international developments” left financial conditions looking scary and kept the Fed on hold, this time around Europe is rebounding nicely and China is orchestrating financial market tightening at home to keep its credit issues from boiling over while so far sustaining growth around 6.5%.

While it’s reasonable for the Fed to incorporate equity market levels into its financial market assessments, the growing level of leverage in the economy should really factor into the Fed’s calculations to a far greater degree, Brady points out. A Fed funds rate slightly above 1% is still very accommodative, particularly in an economy with unemployment below targeted levels and wage growth trending higher, most recently running at an annual 3.5% on the Atlanta Fed’s Wage Growth Tracker.

Whether the Fed is behind the tightening curve and ultimately has to move “more aggressively” than it had anticipated remains to be seen. Its balance sheet reduction will also impact financial conditions, though the modest amounts of maturing mortgage and Treasury bonds that it won’t reinvest may mean that the run-off in the Fed’s balance sheet assets does proceed “in the background,” without generating much volatility and higher-than-desired long-term borrowing rates.

But incremental moves in benchmark rates amid a predictable, gradual reduction in the Fed’s balance sheet may not be the elixir needed to keep the “expansion on a sustainable path.” Economic dynamics can shift faster than consensus thinking on the Federal Open Markets Committee, not to mention the normal 12- to 18-month lag in transmission of monetary policy to the broader economy.

Inflation, unemployment, economic growth and interest rate forecasts, in this regard, are always to some degree suspect. So investors would be well advised to have portfolios built for a variety of economic outcomes, populated with individual securities chosen based on their relative valuations and attractiveness, the prospects of their issuers, and their fit within the broader portfolio. Risks, like monetary policy, may build incrementally. But unlike monetary policy, too many underappreciated risks can quickly throw markets into a tailspin. Investors who take too many risks without adequate compensation, amid rosy macro forecasts and market complacency, may well see their returns suffer if the currently richly valued market turns south.

This isn’t to suggest a repeat of the scenario a decade ago is around the corner. But the possibility that accommodative financial conditions could cause the economy to overheat and frothy financial assets to correct sharply shouldn’t be ignored. Good, risk-adjusted returns depend on that recognition.

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Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact your financial advisor or visit our literature center. Read them carefully before investing.

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Charles Roth is global markets editor for Thornburg Investment Management. Prior to joining Thornburg in 2013, Charles was an assistant managing editor at Dow Jones Newswires, the Wall Street Journal’s real-time financial news and analysis division, where he oversaw its bureaus in Latin America as well as the New York–based emerging markets group. He had previously served as a senior writer in the emerging markets group, bureau chief in Venezuela, and staff reporter in Malaysia.

Charles earned BA degrees from the University of Colorado at Boulder and an MA from the Instituto Universitario de Desarrollo y Cooperación at the Universidad Complutense in Madrid, Spain. He was a Peace Corps volunteer in Mali.

Charles Roth is global markets editor for Thornburg Investment Management. Prior to joining Thornburg in 2013, Charles was an assistant managing editor at Dow Jones Newswires, the Wall Street Journal’s real-time financial news and analysis division, where he oversaw its bureaus in Latin America as well as the New York–based emerging markets group. He had previously served as a senior writer in the emerging markets group, bureau chief in Venezuela, and staff reporter in Malaysia.

Charles earned BA degrees from the University of Colorado at Boulder and an MA from the Instituto Universitario de Desarrollo y Cooperación at the Universidad Complutense in Madrid, Spain. He was a Peace Corps volunteer in Mali.

Danan Kirby is a portfolio specialist for Thornburg Investment Management. He works with Thornburg’s investment team and serves as a liaison for the team and key investment decision makers, communicating process and results of the firm’s investment strategies. Danan joined Thornburg in 2016.

Prior to Thornburg, Danan served as portfolio manager for the Strategic Growth Bancorp family of banks, managing various strategies for institutions and individual investors. Before that, he was a financial institution specialist with the FDIC. He is also a veteran of the U.S. Army. Danan graduated summa cum laude from the University of New Mexico’s Anderson School of Management with a BBA, concentrating in finance.

Charles Roth is global markets editor for Thornburg Investment Management. Prior to joining Thornburg in 2013, Charles was an assistant managing editor at Dow Jones Newswires, the Wall Street Journal’s real-time financial news and analysis division, where he oversaw its bureaus in Latin America as well as the New York–based emerging markets group. He had previously served as a senior writer in the emerging markets group, bureau chief in Venezuela, and staff reporter in Malaysia.

Charles earned BA degrees from the University of Colorado at Boulder and an MA from the Instituto Universitario de Desarrollo y Cooperación at the Universidad Complutense in Madrid, Spain. He was a Peace Corps volunteer in Mali.

Stephen Jimenez is a client portfolio manager for Thornburg Investment Management. He focuses on Thornburg’s liquid alternative strategy and serves as a liaison between the investment team and clients.

Prior to joining Thornburg, Stephen was a salesperson at III Capital Management, a $4 billion hedge fund management company focused on rates and credit strategies. He also held various positions in the alternative asset management industry, including Coast Investment Management, a $7 billion fund of hedge funds. His roles included global product specialist and hedge fund analyst, focused on fixed income relative value strategies. Earlier in his career he was a U.S. Treasuries market maker and arbitrageur at major Wall Street firms, including Bank of America and UBS.

Stephen attended the University of Washington, where he graduated with a BA in economics. He is currently registered with FINRA with a Series 7 and 66.

Charles Roth is global markets editor for Thornburg Investment Management. Prior to joining Thornburg in 2013, Charles was an assistant managing editor at Dow Jones Newswires, the Wall Street Journal’s real-time financial news and analysis division, where he oversaw its bureaus in Latin America as well as the New York–based emerging markets group. He had previously served as a senior writer in the emerging markets group, bureau chief in Venezuela, and staff reporter in Malaysia.

Charles earned BA degrees from the University of Colorado at Boulder and an MA from the Instituto Universitario de Desarrollo y Cooperación at the Universidad Complutense in Madrid, Spain. He was a Peace Corps volunteer in Mali.

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Danan Kirby is a portfolio specialist for Thornburg Investment Management. He works with Thornburg’s investment team and serves as a liaison for the team and key investment decision makers, communicating process and results of the firm’s investment strategies. Danan joined Thornburg in 2016.

Prior to Thornburg, Danan served as portfolio manager for the Strategic Growth Bancorp family of banks, managing various strategies for institutions and individual investors. Before that, he was a financial institution specialist with the FDIC. He is also a veteran of the U.S. Army. Danan graduated summa cum laude from the University of New Mexico’s Anderson School of Management with a BBA, concentrating in finance.

Stephen Jimenez is a client portfolio manager for Thornburg Investment Management. He focuses on Thornburg’s liquid alternative strategy and serves as a liaison between the investment team and clients.

Prior to joining Thornburg, Stephen was a salesperson at III Capital Management, a $4 billion hedge fund management company focused on rates and credit strategies. He also held various positions in the alternative asset management industry, including Coast Investment Management, a $7 billion fund of hedge funds. His roles included global product specialist and hedge fund analyst, focused on fixed income relative value strategies. Earlier in his career he was a U.S. Treasuries market maker and arbitrageur at major Wall Street firms, including Bank of America and UBS.

Stephen attended the University of Washington, where he graduated with a BA in economics. He is currently registered with FINRA with a Series 7 and 66.

Charles Roth is global markets editor for Thornburg Investment Management. Prior to joining Thornburg in 2013, Charles was an assistant managing editor at Dow Jones Newswires, the Wall Street Journal’s real-time financial news and analysis division, where he oversaw its bureaus in Latin America as well as the New York–based emerging markets group. He had previously served as a senior writer in the emerging markets group, bureau chief in Venezuela, and staff reporter in Malaysia.

Charles earned BA degrees from the University of Colorado at Boulder and an MA from the Instituto Universitario de Desarrollo y Cooperación at the Universidad Complutense in Madrid, Spain. He was a Peace Corps volunteer in Mali.

Charlie Wilson is portfolio manager for Thornburg Investment Management. He joined the firm in 2012 as ­associate portfolio ­manager and was promoted to portfolio manager in 2014.

Charlie earned a BS in geology from the University of Arizona in Tucson and a PhD in geophysics from the University of Colorado in Boulder. Prior to joining Thornburg, Charlie served as co-portfolio manager for Marsico Capital Management in Denver, Colorado. He was responsible for portfolio investments across multiple strategies and geographies, with specialization in materials, energy, technology, and payments sectors.

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